Tax treatment depends on whether you contributed pre-tax or after-tax money

When you take money out of an annuity, the tax you owe depends on what kind of money went in. If you funded the annuity with pre-tax dollars — typically through a workplace plan or traditional IRA — your entire distribution is taxed as ordinary income. If you funded it with after-tax dollars, only the earnings portion is taxed; your original contributions come out tax-free. Most annuities are pre-tax, so most distributions are fully taxable.

The IRS treats annuity payouts the same way it treats other retirement income. Money that was never taxed when it went in gets taxed when it comes out. This is called the exclusion ratio method for after-tax annuities — it calculates what portion of each payment is a return of your contribution (tax-free) versus earnings (taxable).

Key Takeaways

  • Pre-tax annuity distributions are taxed as ordinary income at your full tax rate, whether you withdraw a lump sum or take payments over time.
  • After-tax annuity distributions use an exclusion ratio to separate your contributions (tax-free) from earnings (taxable) in each payment.
  • Withdrawals before age 59½ from most annuities trigger a 10 percent early withdrawal penalty on top of income tax, with limited exceptions.
  • may have access to longevity annuities (QLACs) have different rules and can defer taxes until much later, but contributions are capped at $145,000 per person as of 2024.
  • Annuities held inside IRAs follow IRA withdrawal rules; annuities held outside IRAs follow different rules and may have surrender charges.

How pre-tax annuity distributions are taxed

A pre-tax annuity is one you funded with money that was not yet taxed — either through a 401(k), 403(b), traditional IRA, or a non-may have access to annuity purchased with pre-tax dollars. When you receive a distribution, the entire amount is taxed as ordinary income at your marginal tax rate. If you are in the 24 percent federal tax bracket, you owe 24 percent on the distribution, plus any state income tax that applies.

This is true whether you take a lump sum, a series of payments, or a lifetime income stream. The IRS does not distinguish between different payout structures — all of it counts as taxable income in the year you receive it. If you take $50,000 from a pre-tax annuity in one year, you report $50,000 as income on your tax return.

How after-tax annuity distributions are taxed

An after-tax annuity is one you funded with money you already paid income tax on — typically a non-may have access to annuity purchased with savings. When you withdraw, the IRS uses the exclusion ratio to determine what portion of each payment is your original contribution (tax-free) and what portion is earnings (taxable).

The exclusion ratio is calculated as: your total contributions divided by the total value of the annuity at the time distributions begin. If you put in $100,000 and the annuity is worth $150,000 when you start taking payments, your exclusion ratio is 67 percent ($100,000 ÷ $150,000). This means 67 percent of each payment is tax-free and 33 percent is taxable. The ratio stays the same for the life of the annuity, even as the value changes.

The IRS publishes life expectancy tables that determine how long the exclusion ratio applies. Once you have recovered your full contribution amount, all remaining payments are fully taxable. This calculation can be complex, and many people work with a tax professional to track it correctly.

Early withdrawal penalties before age 59½

If you withdraw from an annuity before you turn 59½, you typically owe a 10 percent early withdrawal penalty on top of income tax. This applies to the taxable portion of the withdrawal. For a pre-tax annuity, that is 10 percent of the entire amount. For an after-tax annuity, it is 10 percent of the earnings portion only.

Some annuities have exceptions to this penalty. If the annuity is inside an IRA, you may avoid the penalty if you take substantially equal periodic payments (SEPP) under IRS Rule 72(t). If the annuity is outside an IRA, the annuity contract itself may allow penalty-free withdrawals under certain conditions — check your contract. Annuities held in workplace plans like 401(k)s may have different rules if you separate from service at 55 or older.

Annuities inside IRAs versus non-may have access to annuities

An annuity held inside a traditional IRA follows IRA withdrawal rules. Distributions are taxed as ordinary income, and early withdrawals before 59½ face the 10 percent penalty unless an exception applies. Required minimum distributions (RMDs) begin at age 73 (as of 2023) and must be taken annually.

A non-may have access to annuity — one purchased outside an IRA with after-tax money — follows different rules. It may have a surrender period, typically 5 to 10 years, during which withdrawals beyond a small annual amount trigger a surrender charge (a fee imposed by the insurance company). After the surrender period ends, you can withdraw without penalty, though you still owe income tax on earnings. Non-may have access to annuities do not have RMDs, so you can leave the money untouched as long as you want.

may have access to longevity annuities (QLACs) and deferred tax treatment

A QLAC is a special type of annuity that lets you defer taxes on a portion of your IRA or 401(k) until much later — typically age 80 or 85. You purchase the QLAC with IRA or 401(k) money, and that amount counts toward your RMD but is not distributed to you when ready. When payments finally begin, they are taxed as ordinary income.

As of 2024, you can put up to $145,000 into a QLAC per person (or $290,000 for a married couple if each spouse has their own QLAC). This limit is set by the IRS and may change. QLACs are designed for people who want to may provide income later in retirement and do not need the money right away. The tax deferral is the main advantage — you avoid paying tax on that portion of your retirement account for years.

State income tax on annuity distributions

Most states tax annuity distributions as ordinary income, just like the federal government does. A few states — including Illinois, Mississippi, and Pennsylvania — have special rules that exempt or reduce tax on certain retirement income, including annuities. The rules vary widely by state and by the source of the annuity (IRA, 401(k), or non-may have access to).

If you move to a different state after you start taking annuity payments, your tax situation may change. Some states tax you based on where you lived when you received the payment; others tax based on where you live now. This is particularly important if you move from a high-tax state to a low-tax or no-tax state. A tax professional in your state can tell you how your specific annuity will be treated.

Frequently Asked Questions

Do I owe taxes on annuity distributions if I already paid taxes on the money going in?

Only if the annuity is after-tax (non-may have access to). You owe tax on the earnings portion, but not on your original contributions. If the annuity is pre-tax (traditional IRA or 401(k)), you owe tax on the entire distribution because the original contributions were never taxed.

What happens if I withdraw from an annuity at age 58?

You owe income tax on the taxable portion, plus a 10 percent early withdrawal penalty. The penalty applies to the entire distribution if the annuity is pre-tax, or to the earnings portion if it is after-tax. Some annuity contracts allow penalty-free withdrawals; check your contract or ask your insurance company.

How do I know if my annuity is pre-tax or after-tax?

Check your annuity contract or the statement from your insurance company. If the annuity is inside a traditional IRA, 401(k), or 403(b), it is pre-tax. If you purchased it outside a retirement account with your own savings, it is after-tax. Your insurance company can also tell you the cost basis (what you contributed) versus the current value.

Can I avoid the 10 percent penalty by taking substantially equal payments?

Yes, if the annuity is inside an IRA. You can use IRS Rule 72(t) to take penalty-free withdrawals before 59½ if you commit to a specific payment schedule. The payments must continue for five years or until you turn 59½, whichever is longer. Non-may have access to annuities do not have this option, but some contracts allow penalty-free withdrawals under their own terms.

Are annuity distributions subject to Medicare premiums or Social Security tax?

Annuity distributions count as income for Medicare premium calculations (IRMAA) and may affect how much you pay for Part B and Part D. They also count toward the combined income test for Social Security taxation, which determines whether your benefits are taxed. The exact impact depends on your total income for the year.